• Subject Name : Accounting and Finance

Commodity Price Risk

Why so some commodity companies choose to hedge their commodity exposure?

Answer 1)

Commodity price risk is defined as the possibility that the changes in prices of the commodity may led to financial losses for the producers or buyers of the commodity. They face the risk the commodity price may increase than their expectations (Gaudenzi et al. 2018). For instance, furniture manufacturers should buy the wood as the high prices of wood will raise the cost of making furniture and therefore unfavourably influence the profit margins. Lower prices of the commodities are considered as a risk for the producers of the commodity. For instance, if the prices of crops are high in the current year, then the farmer may plan to plant more of that particular crop on comparatively less fertile or productive land area. However, if the price of crop decreases in the next year, then as a consequence of this, the farmer may lose the money on the extra harvest done on less productive land (Li et al. 2017). This is another kind of commodity price risk. Similarly, the manufacturers of automobile also face commodity price risk as they make use of various commodities such as rubber, iron, rubber and steel for manufacturing cars. The producers of various commodities face the risk that the prices of commodities will decline unexpectedly that may led to lower profit margins or may even led to losses for the producers.

To avoid all this risk, most of the companies chose to hedge their commodity exposure. Hedging is considered as an efficient way to decrease the risk exposure by grabbing an offsetting position in a closely related security or product. Futures are considered as the popular asset to hedge against commodity exposure (Kang et al. 2020). It can be used by both producers and consumers. Hedging with future contracts or agreements may effectively locks in the commodity price, even if the commodity is to be actually bought or sold in physical form in the future time period. Consumers and producers of commodities undertake futures markets to safeguard themselves against the unfavourable movement of commodity prices that may result in huge financial losses. A producer of a commodity faces risk when it moves lower whereas consumer of the commodity faces risk when price moves higher. Hedging is considered as an effective tool that will provide guarantee to both producers and consumers to acquire set price for their output. Future contracts provide a mechanism to the producers and consumers to hedge their respective positions in the commodities. These are regarded as liquid instruments that means there are number trading activities in them and are generally easier to sell and buy.

What are the implications for an investor investing in these companies?

Answer 2)

There are both positive and negative implications for the investors investing in commodity companies. The investment in commodities markets helps the investors in diversifying their portfolios. Diversification means investing in different assets that are usually not related to each other (Miralles-Quiros et al. 2019). A rapid rise in demand for the commodities may led to the rise in prices of the commodities. This provides a number of opportunities to acquire quick income by investing in commodity markets. Moreover, this also provides a hedge against inflation. It is considered essential that the returns generated from any investment must beat out the inflation rate. Higher rate of inflation reduces the real returns on investments. In case of commodities investment, returns will higher when the inflation is high. The commodity prices can change significantly because of several factors like demand and supply, natural calamities, changes in exchange rates and economic well being of the nation. Adequate research and efficient implementation of investment strategy in commodities will surely help the investors to enhance the overall returns on their investment portfolio (Finsen 2018).

Common way to invest in commodities ifs through a futures contract. This is considered as a standardised agreement to buy or sell the underlying asset at the defined price on a specified date. Another option available to the investors to diversify their commodities holding is commodity ETFs. However, it is comparatively considered difficult for the retail investors to understand the commodities markets than stock markets. Stocks can be easily bought or sold at the current market prices without indulging into futures contracts. However, in commodities markets, investors with less knowledge may face severe losses. Commodities are considered as the highly volatile security as compared to other assets. This volatility factor makes the investment in commodity market riskier. Investment in commodities may not generate adequate income or returns for the investors (Struthers 2017). Another implication is that the trading in futures is based on margins. As a result of this, investors are required to have the capacity to pay for call margins to obtain profits from the rising trend. Investors will receive a margin calls from brokers in case when the value of their one or more security that have been purchased by them by paying a proportion of money falling below a set level. Also, the minimum amount that can be invested in the commodities is very high that may not be affordable or feasible for most of the retail investors.

References for Commodity Price Volatility

Finsen, K.Ó., 2018. Hedging Strategies To Manage Commodity Price Risk (Doctoral dissertation).

Gaudenzi, B., Zsidisin, G.A., Hartley, J.L. and Kaufmann, L., 2018. An exploration of factors influencing the choice of commodity price risk mitigation strategies. Journal of Purchasing and Supply Management, vol. 24, no.3, pp.218-237.

Kang, W., Rouwenhorst, K.G. and Tang, K., 2020. A tale of two premiums: The role of hedgers and speculators in commodity futures markets. The Journal of Finance, vol. 75, no. 1, pp.377-417.

Li, N., Ker, A., Sam, A.G. and Aradhyula, S., 2017. Modeling regime‐dependent agricultural commodity price volatilities. Agricultural economics, vol. 48, no. 6, pp.683-691.

Miralles‐Quirós, J.L., Miralles Quirós, M.M. and Nogueira, J.M., 2019. Diversification benefits of using exchange traded funds in compliance to the sustainable development goals. Business Strategy and the Environment, vol. 28, no. 1, pp.244-255.

Struthers, J., 2017. Commodity Price Volatility: An Evolving Principal–Agent Problem. In Future Fragmentation Processes: Effectively Engaging with the Ascendancy of Global Value Chains, pp 79-88. Commonwealth Secretariat.

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